International Flavors And Fragrances: Passing The Smell Test In '16

| About: International Flavors (IFF)

Summary

IFF's outperformance of the S&P 500 Index seems to have paused, as analysts trim their estimates.

Inchoate worries about currencies and emerging markets seem to be driving these revisions, but neither should be as big a concern as the Street seems to think.

IFF seems gradually to come to grips with changes in its competitive landscape, and is in a position to grow more rapidly than investors seem to believe.

I was surprised at an SA colleague's description of International Flavors and Fragrances (NYSE:IFF) as flying "under the radar," "boring" and "behind the scenes" ─ quite a come-down for a charter member of the "Nifty Fifty!" But it is a measure of IFF's success that the idea of putting synthetic flavors or fragrances into food, beverages, cosmetics, household products and virtually everything else is no longer remarkable. In the sixties, it was astonishing that such products could be synthesized at all. Another, rather backhanded measure of IFF's success is that it is increasingly being asked to source its products "naturally."

stock chart

source: Yahoo! Finance

The chart suggests that IFF has not entirely lost its status as a growth stock, as does its price, at 20.1X consensus estimates for 2016. Clearly, investors questioned its growth in the first half of the period shown, for reasons that are obvious:

But they have had no grounds for complaint about the way its stock has performed since 2008.

While it is ordinarily, and correctly, associated with the consumer staples sector, in fact IFF is a fine chemicals business. Many naturally-occurring odors and flavors are chemically unstable, and their unaltered use in manufacturing would result in short shelf lives and numerous returns of allegedly tainted (but in fact just degraded) product. IFF's job is to identify effect chemicals, to find ways to preserve and stabilize them and economic ways to produce them. This is both art and science: the degree to which chemical combinatorics can now be applied to the task would have astonished earlier generations, but the end result must meet demanding subjective criteria. Sourcing from "nature" rather than synthetically makes no fundamental difference to the task: the product must be chemically pure and stable for it to meet the demands of manufacturers for shelf life, consistent effect and chemical compatibility with their products' other ingredients, including their packaging. All of which is reflected in a research budget equivalent to 8.2% of 2014 sales.

The growth of large-scale commercial food manufacture is an aspect of economic development, and demand for IFF's products has spread dramatically since it was formed through the merger of a Dutch and an American company in 1958. Although product sourcing has always been geographically adventurous, product sales were largely restricted to the U.S. and Europe at first, but this is no longer the case:

IFF Revenue Distribution

source: IFF

However, IFF's geographic spread of activities is not entirely a matter of its own decision to expand into developing markets: it also resulted from losing share in its primary U.S. and European markets, where competition has become steadily more difficult since the 1980s.

Market Shares

Consolidation among major food manufacturers contributed to this more demanding environment. But far more significant has been the rapid expansion since the 1980s of major household products manufacturers such as Procter & Gamble (NYSE:PG) and Unilever (NYSE:UL) into the beauty and personal care markets. Further, in more traditional household products, fragrance has become a much more important selling point ─ for some heavily promoted products, it is the only selling point. IFF reports that its twenty-five largest customers account for 53% of its revenue. Such strong customers have correspondingly strong bargaining power with their suppliers.

In particular, they can demand degrees of customization and exclusivity that are expensive to provide and limit the potential market for molecules that may not have been cheap to develop. There are, of course, numerous standard flavors and fragrances, used in many different and perhaps even competing products: think of all the smells you encounter in a supermarket's cleaning goods aisle. And there are absolutely top secret formularies for high end perfumes, known only to their manufacturers. In between are products like scented deodorants or odor-disseminating wall plugs, for which the manufacturer wants exclusivity but is likely to need to use synthetic fragrances. It is in this latter category that the industry has seen the strongest growth, and IFF has not always been the most effective competitor there, but it seems to be correcting for this shortcoming.

Given the geographic spread of its activities, currency movements have been a headache for IFF since the summer of 2014. Assuming it does not resume its slide, the Euro ─ its single most important currency exposure ─ will cease to offer negative year-on-year comparisons at the end of March. This would also probably enhance IFF's competitive position a little: its principal competitors are European. Although price is one of the less important competitive factors at the upper end of these markets, it is quite important for IFF's more commodity-like product lines.

Analysts are looking for a 5.8% increase in IFF's 2016 earnings, similar to what they expect for 2015 over 2014. This implies that they expect currency conditions to remain adverse, because there is no obvious reason why volume growth should slow or pricing deteriorate. Everyone knows that currency forecasting is a dark art, but I am unaware of evidence that consumer staples analysts are better at it than others. Having been forced to reduce their estimates in response to a factor that was plain for all of them to see but that they apparently did not understand, they are now finding currency risk everywhere. Similarly with regard to emerging market risk: IFF is precisely the sort of company that avoids this sort of risk. Analysts' "twice shy" approach is in the process of creating value in IFF.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.